Making Sense of the Price of Gasoline

2008-02-R9

(Copyrighted 2008 by Don M. Tow)

What are the reasons for the huge profits of the big U.S. oil companies in 2007, and are they justifiable?  We have probably all heard of the huge profits that the big U.S. oil companies made in 2007.  For example, the 2007 profits of the big five oil companies in the U.S. are:

• ExxonMobil - $40.6 billion

• ChevronTexaco - $18.7 billion

• BP - $20.8 billion (BP is a British company, but it merged with Amoco in 1998 and has a major presence in the U.S.)

• Shell - $31.3 billion

• ConocoPhillips - $11.9 billion

ExxonMobil’s $40.6B was the highest profit ever made by a public U.S. company.  It  broke the previous record of $39.5B, established by ExxonMobil in 2006, which broke the previous record of $36.1B, also established by ExxonMobil in 2005.

What about the compensations for these oil companies’ CEOs?  I haven’t seen the numbers for 2007 or 2006.  For 2005, the average compensation for the CEOs of the largest 15 oil companies was $32.7M, as compared to $11.6M for the average compensation for all large U.S. firms.  When Lee R. Ramond, ExxonMobil’s former CEO, retired at the end of 2005, his exit package was worth $398 million!

One can’t help but link these companies’ huge profits and the mind-boggling compensation and exit packages of their CEOs to the constantly rising gasoline prices.  To help understand better the cost of gasoline, let’s first understand the cost components of gasoline.

There are four major cost components for gasoline:

1. Crude oil

2. Federal and state taxes

3. Refining costs and profits

4. Distribution and marketing

The first component is the cost of crude oil.  The average price per barrel of crude oil was $36.98 in 2004, $50.23 in 2005, $58.30 in 2006, $64.20 in 2007, and $84.70 in January 2008.  During the month of February 2008, it has been in the $90-100 range, and just recently exceeded $100.  The cost of crude oil is a major cost component for gasoline, e.g., 47% and 53% for 2004 and 2005, respectively.  This percentage varies with time and geographical region within the U.S.  There could also be a profit component hidden in the crude oil item, which we will discuss later in the article.

The second component is federal and state taxes, and in certain parts of the country there could be additional county and local taxes.  Federal and state taxes, not including county and local taxes, for 2004 and 2005 made up approximately 23% and 19% respectively of the cost of gasoline.  The state portion was slightly larger than the federal portion.

The third component is refining costs and profits.  For various reasons, the crude oil that comes out of the ground is not suitable to be used as fuels, lubricants, or for other purposes.  It must be separated into parts and refined before it can be used, e.g., as gasoline to power motor engines.  This process is called oil refinery.  Refining costs and profits make up about 20% of the retail price of gasoline.  I haven’t been able to find the breakdown of this percentage into the refining component and the profit component.  Even when the refinery company is a foreign company, the big U.S. oil companies often own part of that company (e.g., via joint ventures).  So part of the profit of this foreign refinery company when it sells gasoline to the U.S. or other parts of the world also contributes to the bottom line of the partner U.S. oil company.

Gasoline from the refineries needs to be transported via pipelines to regional terminals and then via trucks to individual gas stations.  These gas stations may be owned and operated by oil or refinery companies, or independent businesses that purchase gasoline from the refineries for resale to the public.  These gas stations also need to make a profit.  Since there are multiple oil companies and multiple brand name gas stations, there are also marketing costs.  Therefore, the fourth component is the distribution and marketing costs.  Although not explicitly mentioned in the heading, the distribution and marketing cost component also includes the profits for the retail gas stations.  The distribution and marketing costs make up about 10% of the retail price of gasoline.

These four cost components and their percentages for 2004 and 2005 are summarized in

Figure 1:  What do we pay for in a gallon of regular grade gasoline?

We now revisit the topic of crude oil.  Crude oil can come from oil fields owned by the U.S. oil companies (either inside the U.S. or in other parts of the world) or purchased from oil fields owned by foreign companies, such as from companies owned by the countries of OPEC (Organization of the Petroleum Exporting Countries).  In 2005, about 60% of the crude oil used in the U.S. was imported, with Canada, Mexico, and Saudi Arabia among the top importers (Note:  Canada and Mexico are not members of OPEC).  Crude oil is also sold with a profit for the crude oil producing company.  When the crude oil comes from a U.S. oil company, the profit from that contributes to the bottom line of that oil company.  Since the big U.S. oil companies may also own a portion (e.g., via joint ventures) of the foreign oil companies that produce the crude oil, profit from selling foreign crude oil may also contribute to the bottom line of the big U.S. oil companies.

To help foreign oil or refinery companies to produce crude oil or gasoline, the big U.S. oil companies often also provide to these foreign companies consulting and other technical services, as well as sell to them various oil producing or refinery machinery and equipment.  Therefore, the profits from these foreign oil or refinery companies selling crude oil or gasoline to the U.S. and the rest of the world may also contribute to the bottom line of the big U.S. oil companies.

Summarizing the above, we see that the profits of a big U.S. oil company can come from multiple sources:

• Selling its own crude oil to a U.S. or foreign oil refinery company

• Minority ownership in a foreign oil company that produces the crude oil that is sold to a U.S. or foreign oil refinery company

• Profits from its own refinery when its gasoline is sold to a U.S. or foreign gas station

• Minority ownership in a foreign refinery company that refines the crude oil into gasoline that is sold to a U.S. or foreign gas station

• Providing consulting and technical services to foreign oil or refinery companies

• Selling oil producing or refinery machinery and equipment to foreign oil or refinery companies

• Selling gasoline from its own retail gas stations

Now that we have a better understanding of the cost components of gasoline and the sources of profit for big U.S. oil companies, we can discuss the various potential factors that can contribute to driving up or down the price of gasoline.

1. Cost of producing (exploring and drilling for) crude oil
   
   
2. Cost of refining crude oil into gasoline
   
   
3. Cost of distributing gasoline from the oil refineries to retail gas stations
   
   
4. Natural or man-made disasters that could disrupt the oil/gasoline producing/refining/distribution process
   
   
5. Taxes
   
   
6. U.S. and world demand for oil and gasoline
   
   
7. Supply availability of oil and gasoline
   
   
8. Raising or lowering crude oil price or production capacity to achieve certain political objective, including collusion or price fixing
   
   
9. Changing value of the dollar relative to other world currencies
   
   
10. Greed to make more profits

We now discuss each of the above 10 potential factors that could raise or lower the price of gasoline.  The cost of producing crude oil in the last few years has definitely not increased to the extent to cause the price of crude oil to rise from around $37 in 2004 to close to today’s $100.  Similarly, the cost of refining crude oil into gasoline and distribution of gasoline to the retail gas stations have also not increased to that extent.  Hurricane Katrina and the temporary shutdown of some pipelines in 2005-2006 did significantly reduce the capacity of U.S. crude oil production and the distribution of gasoline.  This definitely contributed to the rising price of gasoline, especially in 2005 and 2006, but does not explain most of the rise and the continued rapid rise.  Changes to taxes levied on oil and gasoline in the last few years definitely does not explain the large and continued rise.  Even combining all these factors still does not get close to explaining the huge rise of the price of gasoline over the last few years. 

The increasing demand for oil and gasoline in the U.S. (which consumes about 25% of the world consumption) and the rest of the world (especially China and India) is a legitimate contributing factor.  Increasing demand will likely increase prices.  However, since the projected demand increase is only about 1.5-2% per year, it does not explain the large increase in gasoline price during the last few years.  Since refinery capacity, especially in the U.S., is being used near its maximum limit, as the demand for gasoline increases, the supply may not be able to keep up with increasing demands, thus driving up prices.  Perhaps the big oil companies are purposely not increasing greatly its refinery capacity to try to keep prices and profits high.  With their huge profits in the last few years, they definitely have the capital to invest in expanding their refinery capacities.  The OPEC countries, perhaps even with tacit approvals or encouragement from the big U.S. oil companies, may also be purposely limiting the increase of its oil/gasoline production to help drive prices up.  As discussed earlier, the big U.S. oil companies often share part of the profits from many of the OPEC countries, thus the reason for the above statement about their tacit approvals or encouragement.

Oil exporting countries and organizations like OPEC may want to raise or lower crude oil price or production capacity to achieve certain political objective.  OPEC was formed in 1960, with the original purpose to protest the pressure by major oil companies (mostly U.S., British, or Dutch companies) to reduce the prices of oil produced in their countries.  Its original membership had five countries:  Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela, and later expanded to its current 13 member countries, with the addition of Algeria, Angola, Ecuador, Gatar, Indonesia, Libya, Nigeria, and United Arab Emirates.  The original objective remained valid for over a decade, as clearly seen in the following statement to the New York Times in 1973 during the height of the Arab-Israeli conflict from the Shah of Iran, whose nation was the world's second-largest exporter of oil, and one of the closest allies of the U.S. in the Middle East at the time:  "Of course the world price of oil is going to rise.  Certainly!  And how...; You Western nations increased the price of wheat you sell us by 300%, and the same for sugar and cement…; You buy our crude oil and sell it back to us, refined as petrochemicals, at a hundred times the price you've paid to us...; It's only fair that, from now on, you should pay more for oil.  Let's say 10 times more.”  Crude oil was priced at around $3 per barrel at that time, which then quickly increased in a year to about $12 per barrel after the 1973 oil embargo.

Even though OPEC still wields a heavy stick in determining the price of crude oil, changes in the last couple of decades have reduced somewhat the dominating effect of OPEC.  One reason is that very large oil reserves have been found in Mexico, so that Mexico is now competing with Saudi Arabia as the second largest importer of oil to the U.S., behind Canada.  Another reason is that there are also large reserves in the part of the world that was formerly the U.S.S.R., which is now made up of multiple countries.  OPEC may also be experiencing internal difficulty, e.g., Indonesia has been considering of withdrawing from OPEC because it has now become an oil-importing, instead of an oil-exporting country.

Collusion or price fixing may not be just due to foreign countries, but it could also be coming from the big U.S. oil companies.  With the many mergers of big oil companies in the last decades, there are now only five large U.S. oil companies (as listed earlier in the article), thus significantly reducing competition.  They don’t have to collude formally which would violate U.S. anti-monopoly laws, but they could act and set prices in a similar way in responding to various external influences.  The end result is that we now have very little price differences for gasoline from the various major U.S. oil companies.

If the U.S. dollar depreciates in value relative to other world currencies or commodities such as gold, then the price of crude oil that is imported from foreign countries will most likely rise.  Since during the last year or so, except for a few small periods of exceptions, the U.S. dollar has been depreciating in value relative to, e.g., the Canadian dollar, European Union euro, Japanese yen, and Chinese yuan, this depreciation of the U.S. dollar has contributed to rising imported crude oil prices.  Conversely, if the U.S. dollar appreciates in value relative to other world currencies, then if everything else is equal, the price of imported crude oil will go down.   

In a drive to maximize profits for the company and for the company’s senior executives, there could be greed.  Whenever there is an opportunity to make more profits, independent of the adverse consequences for the country and for the average American, they may go after more profits.  When it is so clear that the U.S. oil companies should use some of their huge profits to increase significantly their oil refining capacities in order to facilitate a larger supply of gasoline, they have not done so.  When it is also so clear that they should invest some of their huge profits to pursue alternative forms of energy, they have not done so.  Since 2001, the big U.S. oil companies have earned more than half-a-trillion dollars in profit, yet they have devoted less than a penny per gallon to produce clean and affordable renewable fuels to reduce America’s dependency on oil. 

One may argue that the U.S. government has already looked into the issue of whether the big U.S. oil companies are making unreasonably large profits, and the government might have concluded that those large profits are reasonable.  Just because the people in power have said this doesn’t mean that the big U.S. oil companies are acting with the best interest of the country in mind.  As a matter of fact, the White House and certain segments of Congress may have the interest of the big U.S. oil companies in mind more than the interest of the American people.  That might explain why President Bush and his allies in Congress have blocked efforts to repeal oil company tax breaks that would have devoted those resources as incentives for the production of energy efficient vehicles and renewable energy.

In conclusion, there are multiple contributing factors to the recently continued and rapid increase of the price of gasoline.  These factors include:

• Rising world demand for oil and gasoline

• Natural disaster (e.g., Hurricane Katrina) or man-made events (e.g., Alaska pipeline shutdown)

• Shortage of supply, e.g., U.S. refineries operating at near maximum capacity

• Increasing cost of gasoline distribution, partially due to the higher cost of gasoline that is needed for distribution trucks

• Political collusion, e.g., OPEC agreement to reduce production or raise prices

• Minimizing competition via common pricing strategy among the big oil companies

• Depreciation of the dollar

• Lack of investments to explore alternative energy sources

• Greed to make more profits

Some of these factors are not under the control of the big U.S. oil companies, e.g., rising world demand for oil/gasoline, and natural disasters.  Some are directly due to the actions of the big U.S. oil companies, e.g., lack of actions to increase significantly their oil refinery capacities, lack of investments to explore alternative energy sources, greed to make more profits.  There are also factors related to the actions of the big U.S. oil companies that could contribute in a non-obvious way to rising gasoline prices, e.g., reducing competition via common pricing strategy, collaborating behind-the-scenes with oil producing countries to reduce oil production or raise prices, raising gasoline prices that cause other industries to suffer and thus resulting in inflation and weakening of the U.S. dollar. 

I believe the conclusion is that direct and indirect greed among the big U.S. oil companies has contributed to the large and continued rise of gasoline prices, and there is no justifiable reason for the big U.S. oil companies to make such huge profits for several consecutive years.

  

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